Understanding U.S. Regional Cyclical Comovement: How Important are Spillovers and Common Shocks?

Abstract

The holy grail of the study of business cycles is identifying the source of economic fluctuations that affect an economic region. For anyone participating in the quest there are three paths. First, shocks might be region-specific, affecting only one region of a broader economy. An obvious example is a weather-related shock. Second, they might be common to all regions, such as a change in federal tax rates or monetary policy. Finally, they might initially be region-specific, originating in one region, but eventually spill over to another. The high level of business cycle comovement among U.S. regions suggests that region-specific shocks have a minor role in regional business cycles, leaving spillovers and common shocks playing the major parts in regional business cycles. Despite the growing literature on the subject of regional business cycles, the question of whether the high level of regional business cycles comovement is the outcome of spillovers of shocks from one region to another or common shocks remains unanswered. The purpose of this article is to determine the extent to which fluctuations in regional economic activity are driven by common and region-specific shocks (including spillovers of shocks across regions). The scope of my analysis is limited to real quarterly per capita income data for the eight Bureau of Economic Analysis (BEA) regions, covering the period from 1961:Q1 to 2000:Q4. I use these data to estimate a model of regional business cycles. This model allows me to decompose a region's cyclical innovations into a part that is common across regions and a residual component that is region-specific. At the same time, the model's structure is rich enough to allow me to formally test whether these region-specific shocks spill over to other regions with at least a lag of one quarter. Using this framework, I find that spillovers of region-specific shocks across regions account for a statistically insignificant share of the business cycle variation of regional per capita income across the eight BEA regions, while common shocks account for a large and statistically significant share of the business cycle variation of regional income. Based on these findings, I conclude that the high degree of business cycle comovement across U.S. regions over the last 40 years reflects the fact that regions are influenced by common sources of disturbance, rather than any significant spillover of shocks across regions. Given the different industry mix and strong interregional trade across U.S. regions, these results provides evidence against theories of the business cycle that suggest it owes to cyclical fluctuations being transmitted through trade or production linkages. At the same time, my findings support the notion that the U.S. is an optimum currency area, since they reveal that the BEA regions are largely subject to common sources of disturbance to which they have common responses, which suggests that a common monetary policy is the ideal choice for U.S. regions.